The unprecedented amounts of “stimulus spending” which the Obama administration has requested and the Pelosi-Reid Congress has authorized, are expected to eventually lead to higher inflation and increased tax burdens for years to come.

However, this need not be so.

The Congress may reverse course on spending or give the Federal Reserve extraordinary powers to control inflation.

Basically, it comes down to politics — and these are times in which the course of government may change rapidly and unexpectedly — creating great uncertainty.

This heightened uncertainty is bound to be reflected in erratic behavior of the stock and bond markets.

Classic cures for monetary inflation

The type of inflation being ginned up by the Obama administration will be the result of the money supply increasing much faster than the supply of goods and services.

Note: Even this is uncertain, since with a global economy, in a sense, the supply of goods and services relative to a specific country is much greater than within restricted national borders. As long as the dollar remains the world reserve currency, the US may avoid the worst effects of inflation. However, a profligate US administration is already endangering the dollar’s reputation as a safe haven. Without a strong dollar, the benefits which Americans have seen for the last three generations may fade away.

When people have more money relative to the amount of available goods and services, prices rise and inflation gets underway.

If the amount of money continues to rise faster than the supply of goods and services, inflation becomes endemic.

The cure of inflation is either to increase the supply of goods and services faster than the supply of money, or to reduce the volume of money relative to the supply of goods and services.

When the government has approved government spending on an order of magnitude far greater than any conceivable increase in the supply of goods and services (as in the case of the Obama Administration), the only way to avoid inflation would seem to be to reduce the supply of money.

There are three ways to do this (which can be done in any combination):

1. Increase taxes.
2. Remove money from circulation by selling government bonds.
3. Increase bank reserve requirements.

The last item I call the “Nuclear Option”.

How government spending creates inflation

When the Pelosi-Reid Congress approved government spending in amounts greater than government income through taxation, the foundation was laid for increased inflation.

The steps to inflation are easy to understand:

1. Congress approves the disbursement of funds for some purpose (war expense, help for homeless children, a “shovel-ready” spending project, etc. — the “worthiness” of the project is irrelevant);
2. Based on Congressional approval, the Treasury Department makes a disbursement of funds by sending a check to the beneficiary (say, the contractor on a “shovel-ready” project);
3. The recipient of the government check (or it could be a money transfer), deposits the funds in a bank account;

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4. The bank clears the check, which goes to the Federal Reserve, creating funds in the bank’s account with the Federal Reserve (Federal Funds);
5. The money supply has now been increased by the amount of the payment made by the Treasury. However, as the beneficiary withdraws funds from the bank account to pay others, who in turn deposit the same funds in their bank accounts, and as the new money circulates throughout the economy, and as these banks, in turn, make loans based on these deposits, eventually there are more bank account balances than the original payment made by the Treasury. (The Multiplier Effect).

Brain surgery with a blunt instrument

The cures for inflation all involve removing money from circulation.

However, the three most likely options are difficult to calibrate.

If too much money is removed, deflation will result; if not enough, inflation will persist. Each option also has unpleasant political and economic side-effects.

Take taxes, for example.

In the United States, only about half of the population pays income taxes. Those that create jobs are among that portion of the population that pay most taxes. Consequently, to increase taxes not only fails to remove money from those who don’t pay taxes, but tends to discourage those that create jobs — thereby increasing unemployment.

The result is stagflation.

The possibility of removing money from circulation by selling government bonds is limited by the number of investors that actually have money available for such a purpose.

If government spending is sufficiently excessive (as in the case of the Obama administration), the potential for inflation reduces the appeal of investment in government bonds (fear of inflation), while the shortage of funds available for this purpose, leads to higher and higher interest rates, which, in turn, acts as a brake on business expansion.

Again, the result may be stagflation

The Nuclear Option: Increasing bank reserve requirements

Finally, we have the Nuclear Option — increasing bank reserve requirements — which is essentially a way to limit banks’ ability to earn money on bank deposits, decreasing bank profits while impacting the availability of credit.

The Federal Reserve has the power to require banks and depositary institutions to increase or decrease the percent of various classifications of liabilities that must be deposited as cash with the Federal Reserve in a non-interest-bearing account.

(Recently, the Fed was given power to pay interest on such accounts).

Congress has the power to increase or decrease the limits for reserve requirements that may be set by the Federal Reserve, and also to re-define the institutions that may be required to maintain reserves with the central bank.

(For example, Congress could pass a law requiring money market funds to maintain deposits with the Federal Reserve Bank.)

Prior governments that had economic policies similar to those of the Obama administration — the Roosevelt government of the Great Depression and the Jimmy Carter Presidency — both took measures allowing higher bank reserve requirements.

In both the administrations of Jimmy Carter and Franklin Roosevelt, bank reserve requirements were modified during economic hard times.

In the case of Jimmy Carter, the country passed through a period of stagflation.

In the case of FDR,bank reserve requirements were increased during the Great Depression, resulting in deflation and a prolongation of hard times long after the rest of the world had recovered.

See: Reserve Requirements: History, Current Practices, and Potential Reform.

Undoubtedly, if bank reserve requirements were set high enough and applied to enough institutions (banks, broker-dealers, money market funds, foreign bank branches, etc.), it might be possible not only to stop inflation dead in its tracks, but also to eliminate interest costs that future generations might have to bear for Congressional profligacy.

Political limits on fighting inflation

The best defense against inflation is for Congress not to spend too much in the first place.

Once excessive spending has been authorized and inflation gains the upper hand, governments often fall.

It often takes a change of government to stop bad behavior — however, this usually occurs only when economic conditions read the nadir — and the US is not there yet.

In the United States, Congress has greater control of the economy than the Federal Reserve.

Only Congress can authorize excessive spending or grant the Federal Reserve sufficient powers to control inflation once the economy gets out of hand.

Chairman Bernanke doesn’t have a Wizard Hat that will allow him to wave a wand and cure the economic sickness caused by a bad Congress.

It would be unusual for the same Congress that had approved spending that led to inflation to change course and either cancel appropriations already authorized or to give sufficient powers to the Federal Reserve to risk cutting off recovery, in order to control inflation.

Under current legislation, the Fed’s powers to exercise the Nuclear Option (increasing reserve requirements) are limited by the fact that money is able to flow into non-bank lending institutions, such as money market funds, that are not subject to bank reserve requirements.

Inflation seems the most likely outcome

Although the popularity of President Obama has been falling, the decline has not been fast or steep enough to reasonably expect that the Democrats might lose control of Congress in 2010 or that President Obama might not be reelected in 2012.

Without a change in government in the near term,it seems highly unlikely that the United States will be able escape the logical inflationary consequences of profligate Pelosi-Reid Congress and the Obama administration.

The worst period of inflation can be expected to start soon after funds appropriated under the various stimulus packages begin to result in large bills actually being paid by the US Treasury Department, the logical consequence of current appropriations.

This entry was posted on Friday, May 15th, 2009 at 2:48 pm and is filed under Economic Theory, Leadership, Bankers, Brokers. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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